Risks of Operating in Frontier Markets

With multinational and investors significantly vested in emerging markets, focus has shifted to the next big growth opportunity – frontier markets. Though definitions vary, the International Finance Corporation who coined the term agree with different financial institutions that frontier markets have the following characteristics:

• Large populations
• Favorable demographics with a relatively young average age
• A fast growing middle class
• A lower but much faster growing GDP than traditional emerging markets

Financial Risks of Operating in Frontier Markets

Investopedia identifies a number of financial risks associated with moving into frontier markets, including:

• Geopolitical and Political Risks – Many frontier markets are located in unstable areas and as a result geopolitical risks are a serious concern. Political change is another issue that should be considered since a change of government may be accompanied by significant unrest and instability.
• Inflation – This is a constant threat in some frontier markets and may erode investment returns substantially over a long period of time.
• Lack of Transparency – Most frontier markets suffer from a lack of transparency and have inadequate information sources.
• Currency Risk – The steep decline in some emerging market currencies like the Indian Rupee in 2013 highlights the risk posed by investing overseas.

Operational Risks of Operating in Frontier Markets

Apart from these financial risks there are significant number of operational risks as well, such as:

• Lack of Governance – As political systems in frontier  markets are often more linked to personal interests rather than that of the country the governance system has never had the opportunity to become robust. This can result in a lack of consistency, predictability and protection to its citizens leaving all kind of government, legal and regulatory issues open for personal interpretation and application.
• Inadequate and Emerging Infrastructure – As you would expect in fast growing countries the investment in infrastructure can often fall behind the pace of (industrial) growth and urbanisation. This can lead to significant shortages in energy, transport, financial services and education infrastructure.
• Resource Availability and Capability – Almost every frontier markets has a few well regarded universities which educate the privileged few to become the future talent of the country. However there is a significant supply gap due to two main reasons: (1) The gap between these top universities and other higher education institutes is substantial, and (2) There are many temptations for talent to leave the country to pursue better paying opportunities abroad (the brain drain). These combined with a lack of exposure to developed management systems and processes leaves a capability gap, creating a significant resource shortage. Companies end up scrambling for resources and require significant time and monetary investment to bring employees up the curve.
• Living in Fear – As David Brook explained in his NY Times opinion piece: The Republic of Fear, one thing that people from the developed world take for granted is that they can expect the state to provide a basic level of security, allowing them to focus on improving their lives for themselves and their family. In many frontier markets this is not the case. Of course there are security risks  to company assets but David eludes to something much deeper and more raw: The impact that living in a state of fear, where you can’t be sure that your life, loved ones or belongings are safe, has on the psyche and well being of its citizens. Only those who have lived through this can understand the consequences of living in a shadow of fear on the productivity of employees.

Having lived and worked for the past 17 years in many frontier countries, I can attest to the duality of operating in frontier markets. The opportunity are huge but so is are the risks – it’s certainly not for the faint-hearted. Next week I will talk more on operating in frontier markets. Do you have any thoughts on the topic? As always I look forward to discussing them with you.

Photo Credit: Tambako the Jaguar via photopin cc